Central banks expand their role to deal with the crisis

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Before the economic crash caused by the coronavirus pandemic in March, it had been widely assumed that central banks would be largely powerless in the face of another recession.

With interest rates close to the lower bound of zero in many advanced economies, it seemed unlikely to respond to an economic downturn, either by cutting policy rates directly or by using asset purchases to lower rates. without long-term risk.

Concerns about rates proved to be largely justified, but central banks were still able to contain the crisis by expanding the scale, scope and risk of their balance sheet activities.

The wide range of actions taken by the U.S. Federal Reserve and the European Central Bank since March have helped reverse much of the dangerous financial conditions which happened earlier this year.

In his recent Annual Report, the Bank for International Settlements concluded – with apparent approval – that central banks have “deployed their full arsenal of tools, sometimes in unprecedented ways” and “have been able to cross a number of previous red lines to restore stability during this crisis “.

The most obvious innovation has been to speed up and expand their purchases of government bonds, indirectly financing much of the increased budget deficits needed to cope with the crisis.

In just a few weeks, most of the major central banks increased the size of their balance sheets from 7 to 16 percent of gross domestic product, more than in the two years following the 2008 financial crisis.

While dramatic, the economic impact of large-scale government bond purchases is questionable. Unlike 2008-11, there is little to no room for the Fed to reduce the premium investors receive for longer-term U.S. Treasuries, although the spreads between bonds issued by members of the EU have clearly shrunk.

Many governments could have achieved much the same result by financing their budget deficits with new short-term treasury bills. After all, the consolidated public sector balance sheet contains the liabilities of the central bank. According to this interpretation, central banks may have facilitated a fiscal expansion that could have happened anyway.

Another instrument that central banks have adopted on a massive scale in this crisis has been the provision of lender of last resort facilities to the banking sector. Most of them have taken place through open market trading and discount lending. As usual, the BCE relied heavily on targeted refinancing operations to inject liquidity.

However, the Fed has gone much further than the ECB in developing new instruments to restore financial stability and promote credit flows, mobilizing government money in the process. Some of these programs fall under the category of market makers of last resort, a type of intervention which barely existed before 2007.

MMLR activities occur when central banks tackle market illiquidity by directly buying a wide range of risky financial assets or by accepting them as collateral. This allows asset holders to obtain liquidity by lending these securities, rather than having to throw them into the market.

Such interventions are designed to prevent self-sustaining rushes on specific financial products, including money market mutual funds, commercial paper, leveraged bond funds, and asset-backed securities.

In financial systems that depend on non-bank credit providers, there is a strong case for using such MMLR interventions to prevent financial panics, which can lead to permanent reductions in asset, credit and asset prices. ‘economic activity.

The extremely aggressive purchases of government bonds by the Fed in March were aimed at preventing the treasury market from becoming illiquid, causing the world’s most important “safe” asset to leak. It also falls under the MMLR category and was a key moment in ending the financial crisis.

These asset purchases are different from those made under quantitative easing, because MMLR purchases should in theory be reversed as soon as market liquidity is restored.

But other Fed loan programs may be more difficult to decompress. These take place under Section 13 (3) of the Federal Reserve Act, which allows unusual and demanding loans to non-financial and creditworthy entities.

With Treasury guarantees protecting the first tranche from any loss, these programs could theoretically unlock more than $ 4 billion in loans from the central bank to private companies and municipalities. The Main Street Loan Facility, designed to help “last mile” of the loan process for small and medium-sized businesses, could reach $ 600 billion.

While the announcement effects of these programs have been powerful, take was slow.

Now that the Fed has entered this controversial territory, both after 2008 and in the context of the current pandemic, it has dramatically expanded the potential future role of central banks in influencing markets through their balance sheet operations, at least in the event of emergency.

For investors, “don’t fight the Fed” takes on a whole new meaning, even at the lower limit of zero interest rates.

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